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Quarterly Newsletter - Summer 2007

Recent headlines in the British press addressed the latest hike in interest rates, which were rather overshadowed by the ongoing investigation into the latest terrorist threat, and before that it was the long-expected move of Gordon Brown from Number 11 Downing Street to Number 10.

The latest move by the Bank of England to increase its benchmark interest rate by yet another 25 basis points – the fifth such move in the last year – was very much on the cards.  Last month, the nine members of the Bank’s Monetary Policy Committee was split 5:4 in favour of retaining the rate at 5.5%, and Governor Mervyn King was in favour of a hike then.  However, not all commentators agree with this latest move, citing the effects this will have on homeowners and businesses, particularly those in the export sector that are already struggling with the high value of the pound. Retailers also are worried as it will have a negative effect on consumer spending.  One inherent problem with an interest rate increase is the fact that it takes a long time for the desired benefits – in this case curbing inflation – to filter through into the economy.  Hence, the critics argue, it would have been more prudent to wait a little longer to see what impact earlier rises might have.

The planned bombing campaign in London and at Glasgow airport – fortunately bungled and unsuccessful – is a stark reminder of the ever present threat terrorists nowadays pose.  It also highlighted the difficulties the security forces have in preventing such atrocities.  According to reports, MI5 are trying to monitor more than 200 (!) extremist groups in the UK, a gargantuan task in itself.  The latest batch of suspects also proves how quickly “normal” people – UK or foreign born – can be radicalised to become terrorists.  Gordon Brown’s newly appointed Security Minister, Admiral Sir Alan West, stated in an interview that the fight against terrorism could last 15 years.  That, sadly, may be somewhat optimistic, and in our view an awful lot  will depend on what happens in the Middle East, in particular with regards to the Israel/Palestine conflict, rather than what occurs in the UK.

As already mentioned, the papers were full about our new Prime Minister: the “Clunking Fist” now resides in Number 10.  Gordon Brown got this soubriquet courtesy of Tony Blair, when he compared Gordon Brown with “lightweight” David Cameron.  Well, Gordon Brown could have been given his nickname ten years earlier, namely on the occasion when he punched a massive hole through the UK pension system which used to be the envy of the world.  Gordon Brown’s actions are reckoned to have reduced the value of pension funds by at least £100billion, which is a staggering amount and affects, above all, ordinary working people who loyally contributed to their employers’ pension schemes.  Not only did he deliver a knock-out punch, but he also largely ignored the pleas of the injured parties by just about fully reneging on his pledge to bail out those whose pensions disappeared when their employers went bust. The Financial Assistance Scheme, set up in 2004 and promising help to the tune of £400million, has only paid out around £3million by the end of last year, citing administrative delays…

In our last quarterly Newsletter in April, we dealt with three other prominent themes – the US sub-prime mortgage crisis, the impact of private equity and China.  Given that there is currently a parliamentary review in the UK and a debate in the US as to whether private equity should be  taxed   more  equitably,  the   latter  clearly  remains  topical,  whilst  the crisis  within  two Bear Stearns’ hedge funds with sub-prime exposure keeps the US housing debate alive. The third topic, China, remains the real “elephant on the stage”, and it is likely to feature regularly in this Newsletter in future.  Interestingly, two of our themes from the April Newsletter came together in May when China announced that it was taking a 9.9% stake in the US private equity firm Blackstone.  This $3billion investment ahead of the group’s IPO caused a considerable stir among global commentators and is a likely portent of things to come with China increasingly moving centre stage.

The fallout from the dramatic losses in Shanghai in late February caused concern around the world – everywhere except in China, that is!  The Shanghai market powered on to successive new highs, shrugging off the psychological impact of a further 8% drop in one day in early June, and passing through the 4000 level only two months after it had reached 3000. That is 33% growth in two months! One commentator likened the Shanghai market to a runaway train, i.e. a “crash waiting to happen”.

As we have previously stressed, it is important to appreciate the difference between China’s economic performance and the domestic stock market as represented by the Shanghai Composite index.  The economy is forging ahead on double-digit annual growth but there is huge under-utilised capacity and a plentiful supply of labour, boosted by a steady migration to the urban areas.  The economy is booming but not in crisis – inflation as measured by the CPI reached 3.4% in May, a two-year high but hardly indicative of an impending disaster.

The stock markets are somewhat different.  There clearly is a “bubble” appearing in domestically traded “A” shares, driven by the switch of China’s high savings level into stocks – Chinese share trading volumes account for more than 50% of all shares traded in Asia and, during April, exceeded all but the US in magnitude.  Currently, Chinese investors do not pay capital gains tax on stock market gains, whereas they do pay income tax on interest accrued in saving accounts.  This provides a natural shift towards the equity market which is further boosted by the psychological stimuli of over-optimism, a lack of risk awareness and a “me-too” frenzy which characterise momentum-driven markets the world over.

Financial reform is an ongoing process in China but it would appear that the government is trying to avoid the pitfalls of a “big bang” approach as experienced by Russia in the 1990s.  There have been a number of innovations since the floating exchange rate system was broadened in 2005, all designed to create a liquid and open market system. The futures market has been extended to include commodities and financials, foreign exchange controls have been relaxed in an effort to attract foreign investment and the creation of an inter-bank rate has introduced the concept of a yield curve.  These reforms have been accompanied by various attempts to cool investor enthusiasm – the February falls were partly caused by rumours of a tax on share dealing – but it will prove difficult to avoid a political backlash from disgruntled investors should the inevitable bursting of the bubble prove too spectacular. The fact that markets can fall as well as rise is a painful lesson that needs yet to be learned in some quarters!

At Lacomp we see investment opportunities in China, but our investments currently are placed via an investment vehicle with little exposure to the “A” share market in Shanghai, which is confined to domestic investors and a limited number of foreign institutions. The investment vehicle we chose has grown with the Chinese economy but has not experienced the high volatility of the Chinese markets.  Indeed, the best performing UK registered unit trust of the past year has returned 74%, and it just happens to be the China fund we used within the Lacomp World unit trust!

The big danger   of   a Shanghai market collapse would   be psychological rather  than directly impacting on global economic relationships.  It would not necessarily derail the Chinese economy (although political unrest might) and, given its relatively small size, need not have any contagious effect on global markets.  But psychological fears take little notice of such niceties – if someone shouts “Fire!” it takes a brave investor not to join the rush for the exit, and such panic can become self-generating.  Market-moving catalysts need not, of themselves, have any objective relevance, but it is a consequence of market globalisation that news travels fast and, as we all know, bad news travels fastest.

The broader global market recently has not been devoid of crises - real or imagined. Oil prices, traditionally a source of worry for the bears, rose on post-election violence in Nigeria and the anticipation (!) of this summer’s hurricane season in the Gulf of Mexico. In Spain, we saw a spectacular drop in property shares amidst fears that the building boom might have overstretched itself whilst here in the UK, the mighty Tesco has seen its  share price drop by 13.5% on the news that its (still growing!) sales in the non-food sector were slower than expected.  This neatly highlights the impact of short-term considerations that characterise the modern market – Tesco profits have grown year on year and the company is a model for good retail management, yet the share price has been savaged for perceived “underperformance”.

The previously mentioned impact of the sub-prime mortgage situation in the US is still making itself felt although the relative value of global currencies has probably been the chief unsettling factor in equity markets.  A weak dollar has implications for Asian and European exporters whilst the concomitant strengthening of the yen and euro adds to the impact.  Rising inflation expectations have pushed sterling to a 26-year high against the dollar, and oil and gold (both priced in dollars) have weakened in real terms for Europeans, whilst rising to near record highs for US gasoline consumers. In Asia, the strength of recent economic growth has placed the area on a much more secure footing, and there is little concern that the endemic currency crisis of the 1980s will re-emerge as foreign currency reserves now provide an invaluable safety net.

The end-of-term view on Japan is that it “could do better” in light of the dramatic changes that have occurred since the bursting of its real estate bubble way back in 1987.  Many argue that the Bank of Japan was premature in ending the zero interest rate policy, thereby choking off a consumer-led revival.  Left to rely on its traditional export-led recovery, Japan may well have to await the next surge in global economic growth before it can reassert its dominance in Asia.  The worry for Japanese officials must be that China will, by then, have established itself in an unassailable economic position.

The inter-relationships that nowadays characterise the modern global economy make a simplistic analysis impossible – there will always be pluses and minuses – but, on balance, we remain positive towards Europe and Asia, and we expect the American economy to do rather better than is generally felt.  However, global inflation could still prove problematical and lead to a possible slowdown in global economic growth.

Market perception currently is the crucial factor driving share prices, and market perception can be fickle.  Like in the case of the very recent security scares in the UK, there is a need for continued vigilance, and a need to remember where the “exit” signs are!


18th July 2007